Monthly Partner Memo – February 2021

Feb 01, 2021 | Paul Chapman


As we continue to live through lockdown with hope on the horizon, we are seeing a good number of respected market pundits make a ‘market top’ call, and claims that we’re deep into bubble territory.

Friends & Partners,

The internet and social media (and my email!) are lighting up this week with stories like GameStop, AMC, etc and retail investor behaviour in selected speculative names – this is a sideshow and a distraction from process-driven investing that we are focused on. We’ve seen similar stories before – remember when Hertz was bankrupt but the stock was screaming higher, Volkswagen in 2008, and the dotcom bubble. Every Tom, Dick and Harry was buying stocks. Different mechanics at work, but similar undertones. The market is becoming ‘democratized’ now, but fundamental forces will always remain the same longer-term. Now the retail players are also playing the options market in size (industry reports suggest that >41mm call options have traded over the past week and a half. To put this into context, this number is twice the 2019 average). In options trading, when a small retail account enters an order to buy an out-of-the-money call option, the market maker must hedge that position by buying the stock. As shares continue to rise, the market maker must buy even more shares to hedge as the correct hedge ratio increases with price, which causes even more noise in short term pricing as we have recently seen. You don’t want to short these speculative stocks either, the downside can be infinite as some poorly positioned hedge funds are currently experiencing.

For now, investors have justified general market valuations on higher growth companies with low or negative interest rates, making the prospect of future profits more appealing than they would be if interest rates were higher. Investor sentiment is bullish on many measures, and valuations are certainly rich compared to historical absolute levels (though not versus bond yields). It is interesting to note, however, that many past equity bubbles hit higher valuations than we are currently experiencing, but these were in a bond yield environment of ~5+% not ~1%, so bonds were a real alternative when bubbles burst. And remember that ‘bubbles’ can inflate for a very long time, and history suggests that bubbles can inflate even as rates start to rise. My friend Bob Decker, who is one of the more astute ‘macro’ and market pundits in my view, puts it well in noting that “the current backdrop, courtesy of our friends at the Fed, is that there is too much money chasing too few things. This is the hardest part for people to get their collective heads around in bull markets. The 'narratives' that drive markets have fertile ground on which to grow.”

Some Risks to Monitor – Yields, Sentiment and Valuations

A continued upward drift in yields remain the biggest risk to equities in my view, because as yields rise, multiples should fall because investors aren’t as willing to pay for expensively valued stocks once they can generate more of a yield. As the US government cranks spending/stimulus on COVID relief (it doesn’t matter which to markets), this may lead to 1) higher inflation, 2) higher debt, and 3) larger deficits, which should continue to put upward pressure on Treasury yields (and downward pressure on bond prices).

Valuations may not be the be all and end all for where the markets are heading near-term, but over time they certainly matter, and we need to keep a close eye on them. While the path of least resistance has remained higher for equities, we need to be aware of where we stand versus history. While the S&P500 and TSX indices are by no means cheap compared to their own history, valuations remains attractive when placed next to bonds. reflecting a return to normalcy in due course. Following is a good chart showing this:


Unsurprisingly, given the craziness we are seeing around the perceived high-growth names, valuation dispersion continues to sharply widen, so we need to be positioned to both take advantage of this trend while being cognizant of the fact that it will likely normalize in due course. Following is the P/E multiple of top and bottom S&P 500 sector-neutral valuation quintiles:

Sentiment is clearly an issue, but is that the canary in the coal mine? Morgan Stanley’s Cross-Asset Strategist makes an interesting observation in noting that "sentiment measures are better at identifying buying opportunities than market tops. One reason may be that the nature of the events that cause investors to panic means they panic together, creating a strong impulse that leads to an investable low. Optimism, in contrast, is more diffuse and has a harder time producing such a singular moment." That said, we’re at levels not seen since the tech boom:

Is Canada Finally Compelling?

Interestingly, relative to the U.S. market, the TSX currently trades at an extraordinarily deep discount of ~25% on a forward P/E basis. At current valuations, the Canadian market has rarely been this cheap. If we ignore the global financial crisis, we have to go back to the early 2000s to find the last time Canada looked this cheap relative to the U.S.:

An Interesting Counter-Argument to the Bear Market Calls

If we look at retail investor inflows since 2008, $3.1 trillion has flowed into financial assets, and 94% of this went into bonds, while less than $200bn (or 6%) went into equities. Can stocks be in a "bubble" if 94% of investor inflows are into bonds? Rather, wouldn't that make bonds more of a bubble (most of you know by now that I’m no bond bull?) One might be tempted to think the past 12 months shows a more favorable equity flow environment given the run in stocks, but that doesn’t appear to be the case. As the time series chart below shows, investors liquidated stocks at an accelerating pace since 2017. In fact, the past 3 years saw massive outflows from equities, so it doesn’t feel like an absolute ‘top’ quite yet:

Our Conclusion – Where From Here?

Market tops are usually processes, not a defined event. We think that one of the most important services we can provide to our clients in 2021 and beyond is to ensure we are looking at everything (economic events, political events, geopolitical events, earnings, investor sentiment and position) through the lens of “what does it mean for stocks and yields”, because yields have the potential to up-end a positive outlook for stocks. And we want to make sure we are not blindsided by a spike in yields or inflation, because in that environment both stocks and bonds will decline, which is essentially the worst-case scenario for investors. So we position our portfolios and utilize investments that can work through these potential scenarios.

As we look ahead to 2021, we consider 1) the economy and its outlook; 2) market positioning and consensus; and 3) potential negative scenarios. We conclude that the global economy is undergoing a cyclical rebound, and public companies are generally faring well as we peer across the precipice. Household finances are in good shape and the consumer is ready to spend, while companies have pared back supply. Equity markets have continue to surge in response until this past week, and in the near-term, sentiment is stretched and speculative behaviour abounds, and there continues to be risk of an equity correction of 5–15%. But the longer-term outlook remains strong, and we look to pullbacks to tactically deploy cash. I believe that the next 10 years will be where active managers will outperform, so the ETF/indexing portfolio may finally underperform best-in-class managers. John Mauldin summarizes this well in saying “I think the 2020s will once again be the decade of active management. The 2020s are going to be about rifle shots, not the shotgun approach of index funds. This will be a decade to focus on absolute returns as opposed to relative returns. Passive index investing is a relative return strategy and I think it will be a very poor choice in the coming years. As my dad used to say, every dog has its day. Passive investing had the last decade. Active investing is getting ready to take the lead.” We are active investors with defined process, which will we will continue to follow.

Wealth Management Alpha

The following is from my “You Don’t Know What You Don’t Know” series about tax minimization and planning strategies. This month, I assess strategies around charitable giving.

Do you give to charity most years? You may be doing yourself and your charities of choice a disservice by not utilizing a charitable giving program, which can provide substantially more capital to your charity over the long-run (on the same amount of your money contributed), and can create significantly more wealth overall. In another installment of my "You Don't Know What You Don't Know" series, I illustrate why you should consider implementing strategies like a Charitable Gift Program. Read about this in more detail here.